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©2009, The McGraw-Hill Companies, All Rights Reserved
5-1McGraw-Hill/Irwin
Chapter FiveMoney Markets
©2009, The McGraw-Hill Companies, All Rights Reserved
5-2McGraw-Hill/Irwin
Money Markets
• Liquid funds flow between short-term borrowers and lenders through money markets
• Money markets involve debt instruments with original maturities of one year or less
• Money market debt– issued by high-quality (i.e., low default risk) economic units that
require short-term funds
– purchased by economic units that have excess short-term funds
• Money market instruments have active secondary markets
• Liquid funds flow between short-term borrowers and lenders through money markets
• Money markets involve debt instruments with original maturities of one year or less
• Money market debt– issued by high-quality (i.e., low default risk) economic units that
require short-term funds
– purchased by economic units that have excess short-term funds
• Money market instruments have active secondary markets
©2009, The McGraw-Hill Companies, All Rights Reserved
5-3McGraw-Hill/Irwin
Money Market Yields
• Some money market instruments are bought and sold on a discount basis (e.g., Treasury bills and commercial paper)
• Discount yields (idy) use a 360-day year
Pf = the face value of the security
P0 = the discount price of the securityh = the number of days until maturity
• Some money market instruments are bought and sold on a discount basis (e.g., Treasury bills and commercial paper)
• Discount yields (idy) use a 360-day year
Pf = the face value of the security
P0 = the discount price of the securityh = the number of days until maturity
hP
PPi
f
f
dy
360)( 0
©2009, The McGraw-Hill Companies, All Rights Reserved
5-4McGraw-Hill/Irwin
Money Market Yields
• Compare discount securities to U.S. Treasury bonds with bond equivalent yields (ibey)
• Convert bond equivalent yields into effective annual returns (EAR)
• Compare discount securities to U.S. Treasury bonds with bond equivalent yields (ibey)
• Convert bond equivalent yields into effective annual returns (EAR)
hP
PPi f
dy
365)(
0
0
1/365
1/365
h
bey
h
iEAR
©2009, The McGraw-Hill Companies, All Rights Reserved
5-5McGraw-Hill/Irwin
Money Market Yields
• Money market securities that pay interest only at maturity use single-payment yields (ispy) (e.g., jumbo CDs and fed funds) – since ispy uses a 360 day year, compare to bonds by converting to a
365 day year
– to convert a single-payment yield to an effective annual return
• Money market securities that pay interest only at maturity use single-payment yields (ispy) (e.g., jumbo CDs and fed funds) – since ispy uses a 360 day year, compare to bonds by converting to a
365 day year
– to convert a single-payment yield to an effective annual return
)360/365(spybey ii
1/365
360/3651
/365
h
spy hiEAR
©2009, The McGraw-Hill Companies, All Rights Reserved
5-6McGraw-Hill/Irwin
Money Market Instruments
• Treasury bills (T-bills)
• Federal funds (fed funds)
• Repurchase agreements (repos or RP)
• Commercial paper (CP)
• Negotiable certificates of deposit (CD)
• Banker acceptances (BA)
• Treasury bills (T-bills)
• Federal funds (fed funds)
• Repurchase agreements (repos or RP)
• Commercial paper (CP)
• Negotiable certificates of deposit (CD)
• Banker acceptances (BA)
©2009, The McGraw-Hill Companies, All Rights Reserved
5-7
Billions $
Instrument 1990 2004 2007
Treasury Bills $ 527 $ 982 $1,010Fed funds & Repos 372 1,585 2,731Commercial Paper 538 1,310 2,109Negotiable CDs 547 1,379 2,149Banker's Acceptances 52 4 1
Total $2,036 $5,260 $8,000 % of Total in Given Year
Instrument 1990 2004 2007Treasury Bills 26% 19% 13%Fed funds & Repos 18% 30% 34%Commercial Paper 26% 25% 26%Negotiable CDs 27% 26% 27%Banker's Acceptances 3% 0.1% 0.0%
100% 100% 100%
©2009, The McGraw-Hill Companies, All Rights Reserved
5-8McGraw-Hill/Irwin
Treasury Bills (T-Bills)
• T-Bills are short-term debt obligations issued by the U.S. government
• The Federal Reserve buys and sells T-bills to implement monetary policy
• T-bills are virtually default risk free, are highly liquid, and have little interest rate risk
• T-Bills are short-term debt obligations issued by the U.S. government
• The Federal Reserve buys and sells T-bills to implement monetary policy
• T-bills are virtually default risk free, are highly liquid, and have little interest rate risk
©2009, The McGraw-Hill Companies, All Rights Reserved
5-9McGraw-Hill/Irwin
T-Bill Auctions
• 13- and 26-week T-bills are auctioned weekly• Bids are submitted by government securities
dealers, financial and nonfinancial corporations, and individuals
• Bids can be competitive or noncompetitive– competitive bids specify the bid price and the desired
quantity of T-bills– noncompetitive bidders get preferential allocation and
agree to pay the lowest price of the winning competitive bids
• 13- and 26-week T-bills are auctioned weekly• Bids are submitted by government securities
dealers, financial and nonfinancial corporations, and individuals
• Bids can be competitive or noncompetitive– competitive bids specify the bid price and the desired
quantity of T-bills– noncompetitive bidders get preferential allocation and
agree to pay the lowest price of the winning competitive bids
©2009, The McGraw-Hill Companies, All Rights Reserved
5-10McGraw-Hill/Irwin
Quantity ofT-bills
Bid Price 1
2
3
4
5
6
7
SC ST
Noncompetitive Bids
Stop-outprice (PNC)
T-Bill AuctionsT-Bill Auctions
©2009, The McGraw-Hill Companies, All Rights Reserved
5-11McGraw-Hill/Irwin
The Secondary Market for T-Bills
• The secondary market for T-bills is the largest of any U.S. money market instrument
• 22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market– primary dealers trade for themselves and for customers
– T-bill purchases and sales are book-entry transactions conducted over Fedwire
• T-Bills are sold on a discount basis
• The secondary market for T-bills is the largest of any U.S. money market instrument
• 22 primary dealers “make” a market in T-bills by buying the majority sold at auction and by creating an active secondary market– primary dealers trade for themselves and for customers
– T-bill purchases and sales are book-entry transactions conducted over Fedwire
• T-Bills are sold on a discount basis
©2009, The McGraw-Hill Companies, All Rights Reserved
5-12McGraw-Hill/Irwin
T-Bill Prices
• T-Bill prices can be calculated from quotes (e.g., from The Wall Street Journal) by rearranging the discount yield equation
• Or by rearranging the bond equivalent yield equation
• T-Bill prices can be calculated from quotes (e.g., from The Wall Street Journal) by rearranging the discount yield equation
• Or by rearranging the bond equivalent yield equation
fBillTf P
hdyiPP
360)(0
)(/3651
0
beyih
PP
BillT
f
©2009, The McGraw-Hill Companies, All Rights Reserved
5-13McGraw-Hill/Irwin
Federal Funds
• The federal funds (fed funds) rate is the target rate in the conduct of monetary policy
• Fed fund transactions are short-term (mostly overnight) unsecured loans
• Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds
• Fed funds are single-payment loans and thus use single-payment yields
• The federal funds (fed funds) rate is the target rate in the conduct of monetary policy
• Fed fund transactions are short-term (mostly overnight) unsecured loans
• Banks with excess reserves lend fed funds, while banks with deficient reserves borrow fed funds
• Fed funds are single-payment loans and thus use single-payment yields
©2009, The McGraw-Hill Companies, All Rights Reserved
5-14McGraw-Hill/Irwin
Repurchase Agreement
• A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future
• Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities)
• A reverse repurchase agreement is the opposite side of a repo (i.e., it is the purchase of a security with an agreement to sell it back in the future)
• A repurchase agreement (repo or RP) is the sale of a security with an agreement to buy the security back at a set price in the future
• Repos are short-term collateralized loans (typical collateral is U.S. Treasury securities)
• A reverse repurchase agreement is the opposite side of a repo (i.e., it is the purchase of a security with an agreement to sell it back in the future)
©2009, The McGraw-Hill Companies, All Rights Reserved
5-15McGraw-Hill/Irwin
Repurchase Agreement
• The yield on repurchase agreements (iRA) uses a 360-day year like the discount rate, but uses the current price in the denominator like the bond equivalent yield
Pf = the repurchase price of the security
P0 = the selling price of the securityh = the number of days until the repo matures
• The yield on repurchase agreements (iRA) uses a 360-day year like the discount rate, but uses the current price in the denominator like the bond equivalent yield
Pf = the repurchase price of the security
P0 = the selling price of the securityh = the number of days until the repo matures
hP
PPi f
RA
360)(
0
0
©2009, The McGraw-Hill Companies, All Rights Reserved
5-16McGraw-Hill/Irwin
Commercial Paper
• Commercial paper (CP) is the largest money market in terms of dollars outstanding
• CP is unsecured short-term corporate debt issued to raise short-term funds (e.g., for working capital)
• Generally sold in large denominations (e.g., $100,000 to $1 million) with maturities between 1 and 270 days
• CP is usually sold to investors indirectly through brokers and dealers (approximately 85% of the time)
• CP is usually held by investors until maturity and has no active secondary market
• Yields are quoted on a discount basis (like T-bills)
• Commercial paper (CP) is the largest money market in terms of dollars outstanding
• CP is unsecured short-term corporate debt issued to raise short-term funds (e.g., for working capital)
• Generally sold in large denominations (e.g., $100,000 to $1 million) with maturities between 1 and 270 days
• CP is usually sold to investors indirectly through brokers and dealers (approximately 85% of the time)
• CP is usually held by investors until maturity and has no active secondary market
• Yields are quoted on a discount basis (like T-bills)
©2009, The McGraw-Hill Companies, All Rights Reserved
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Negotiable Certificate of Deposit
• A negotiable certificate of deposit (CD) is a bank-issued time deposit that specifies the interest rate and the maturity date
• CDs are bearer instruments and thus are salable in the secondary market
• Denominations range from $100,000 to $10 million; $1 million being the most common
• Often purchased by money market mutual funds with pools of funds from individual investors
• A negotiable certificate of deposit (CD) is a bank-issued time deposit that specifies the interest rate and the maturity date
• CDs are bearer instruments and thus are salable in the secondary market
• Denominations range from $100,000 to $10 million; $1 million being the most common
• Often purchased by money market mutual funds with pools of funds from individual investors
©2009, The McGraw-Hill Companies, All Rights Reserved
5-18McGraw-Hill/Irwin
Banker’s Acceptance
• A Banker’s Acceptance (BA) is a time draft payable to a seller of goods with payment guaranteed by a bank
• Used in international trade transactions to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer)
• Foreign exporters prefer that banks act as payment guarantors before sending goods to importers
• Banker’s acceptances are bearer instruments and thus are salable in secondary markets
• A Banker’s Acceptance (BA) is a time draft payable to a seller of goods with payment guaranteed by a bank
• Used in international trade transactions to finance trade in goods that have yet to be shipped from a foreign exporter (seller) to a domestic importer (buyer)
• Foreign exporters prefer that banks act as payment guarantors before sending goods to importers
• Banker’s acceptances are bearer instruments and thus are salable in secondary markets
©2009, The McGraw-Hill Companies, All Rights Reserved
5-19McGraw-Hill/Irwin
Money Market Participants
• The U.S. Treasury• The Federal Reserve• Commercial banks• Money market mutual funds• Brokers and dealers• Corporations• Other financial institutions• Individuals
• The U.S. Treasury• The Federal Reserve• Commercial banks• Money market mutual funds• Brokers and dealers• Corporations• Other financial institutions• Individuals
©2009, The McGraw-Hill Companies, All Rights Reserved
5-20McGraw-Hill/Irwin
International Money Markets
• U.S. dollars held outside the U.S. are tracked among multinational banks in the Eurodollar market
• The rate offered for sale on Eurodollar funds is the London Interbank Offered Rate (LIBOR)
• Eurodollar Certificates of Deposits are U.S. dollar denominated CDs held in foreign banks
• Eurocommercial paper (Euro-CP) is issued in Europe and can be in local currencies or U.S. dollars
• U.S. dollars held outside the U.S. are tracked among multinational banks in the Eurodollar market
• The rate offered for sale on Eurodollar funds is the London Interbank Offered Rate (LIBOR)
• Eurodollar Certificates of Deposits are U.S. dollar denominated CDs held in foreign banks
• Eurocommercial paper (Euro-CP) is issued in Europe and can be in local currencies or U.S. dollars